In addition to interest rates, the Federal Reserve has several policy instruments at its disposal to address systemic risks to the financial system. However, those alternatives have "real limitations," Fed Governor Daniel Tarullo said recently. As a result, "monetary policy cannot be taken off the table as a response to the build-up of broad and sustained systemic risk," he said.

Tarullo discussed the relationship between financial stability and monetary policy during a February 25 conference hosted by the National Association of Business Economists in Arlington, Va. In particular, he addressed the ongoing discussion of how financial stability ranks compared with the Fed's dual objectives of price stability and maximum employment. "Here the lines of debate seem more sharply drawn than in the area of financial regulation," he noted.

Low rates prompt financial stability concerns
The current low interest rate environment, coupled with the Federal Open Market Committee's forward guidance on the federal funds rate, could induce financial institutions to take on additional risk in a "reach for yield," Tarullo explained. "High-yield corporate bond and leveraged loan funds, for instance, have seen strong inflows, reflecting greater appetite for risky corporate credits, while underwriting standards have deteriorated, raising the possibility of large losses going forward," he said.

In these cases, the Fed has resorted to supervisory responses as opposed to monetary policy. In March 2013, for instance, the Board of Governors and other federal banking agencies issued updated guidance on leveraged lending in response to substantial growth in the volume of such loans and deteriorating underwriting standards. Regulators have also sought to ensure that banks within their purview are sufficiently capitalized to withstand possible interest rate shocks.

Supervision, other measures can help protect financial stability
These ad hoc supervisory tools are useful, but they have limitations. For one, it may take time to determine their effectiveness. Also, "it's not clear that the somewhat deliberate supervisory process would be adequate to deal with a more widespread reach for yield," Tarullo said. Last, these tools are fairly narrow in that they apply only to regulated firms and would do little to address excesses in the so-called shadow banking system. Rather, "this circumstance creates an incentive for intermediation outside of the regulated sector," he added.

Other measures, such as time-varying macroprudential policies, can also help address systemic risks by acting as a "speed bump" of sorts while having a limited effect on the broader economy, Tarullo noted. For example, the countercyclical capital buffer introduced last summer as part of the Basel III regulations would kick in when "credit growth is excessive and is leading to the buildup of system-wide risk," he explained. These types of tools, similar to ad hoc supervisory, have limitations and face challenges in practice.

Still, Tarullo suggests that the combination of existing supervisory tools and other measures "can together reduce the number of occasions on which a difficult tradeoff between financial stability considerations and near-term growth or price stability aims will need to be made."